ARGENTINA

Argentina has experienced slow economic growth since the 1940s.

By the mid-1970s long-term growth declined noticeably, and in

the last half of the 1980s the country suffered its longest

period of stagnation in the century. Savings and investment

rates fell precipitously from the mid-1970s until 1989.

Argentines, responding to the unstable macroeconomic

environment, increasingly saved and invested abroad. Labor

productivity fell ang poverty worsened. This economic

performance was tranceable to chronic public sector deficits and

endemic inflation. Public sector deficits in the late 1970s

ranged from 10 to 14 percent of GDP, and in the early 1980s

surpassed IS percent of GDP. After the return to constitutional

democracy in 1983, public demands to control inflation were

translated into four successive stabilization programs. All

failed to eradicate inflation, and each ended in a more virulent

inflation than the one preceding it. The main reason for these

failures was the inability of the stabilization programs to

redress rapidly and permanently the public sector structural

deficit. Structural deficits emerged from the post-war

organization of the economy. Economic policy from the 1940s was

used to propagate rules and transfers favoring the interests of

private groups with access to power. By the early 1980s public

expenditures approached 40 percent of GDP. Unionized labor

benefitted from high wages, guaranteed employment, and rigid

rules governing hiring and dismissals. Industry benefitted from

highly protected markets, tax exemptions through special

promotion regimes, subsidized credit-or effective grants, as

many loans were not collected-subsidized inputs from public

enterprises, and high prices on sales to public enterprises.

Housing contractors and middleclass home buyers benefitted from

enormous public transfers through earmarked taxes and effective

grants through the Housing Bank. Tobacco growers, sugar growers,

the merchant marine, and other small interest groups enjoyed

special tax breaks. Consumers enjoyed below-cost tariffs from

public enterprise and lax collectioll practices. Provincial

governments could avail themselves of costless credit from the

provincial banks, which the central bank reimbursed. The

military enjoyed expanding budgets, especially over 1976-82, as

well as management perquisites in state companies they

controlled. By 1989 subsidies through the budget, tax

exemptions, agriculcural regulations, public enterprise tariffs,

and central bank rediscounts were estimated to amount to roughly

8 percent of GDP--the equivalent of some $8 billion. The growth

of the state and concomitant rents and subsidies, along with the

capital flight provoked by an inconsistent exchange rate policy,

were financed during the late 1970s largely by external

borrowing through the expanding Eurodollar market at low or even

negative real international interest rates. This permitted the

government to run large deficits and sustain a revalued exchange

rate with relatively low levels of inflation in the second half

of the 1970s. An abrupt end to voluntary foreign commercial

credit in the early 1980s and the sudden rise in real

international interest rates provoked a financial collapse and

placed additional pressure on public finances. The situation was

complicated by the South Atlantic War. The loss of external

finance and lack of adjustment meant the treasury had to resort

to increased inflationary finance through monetary creation. The

private sector, in an effort to avoid the resulting inflation

tax, gradually withdrew its resources from the financial system

and reduced its real holdings of currency ; this, together with

the negative effects of inflation on real tax collections, made

Argentina's economy progressively more unstable in the 1980s.

Even though the deficit fell from near 20 percent of GDP in the

early 1980s to an average of about 10 percent over 1987-89, the

base for the inflation tax shrank even faster--efforts to reduce

the deficit were not fast or permanent enough to convince the

private sector that savings in domestic currency would not be

eroded by inflation. Inflation became high and unpredictable,

and the main impediment to the recovery of private savings and

investment. The decade ended with two episodes of hyperinflation

in 1989.

Post-1989 Structural Reforms

Tbe present administration took office in July 1989 during a

traumatic hyperinflation--July inflation alone was 200 percent.

This culminated a decade-long crisis in public finance. The new

team inherited weak public institutions accustomed to deficit

spending and with an institutionalized reliance on the inflation

tax. In addition, claims on state revenues were far greater than

its capacity to mobilize resources-in short, the Argentine state

was insolvent. The government undertook stabilization programs

in 1989 and 1990. Neither succeeded, principally because of the

intractability of the fiscal deficit. The first terminated in a

new hyperinflation at the end of 1989 and in early 1990. The

second lasted from March 1990 to December 1990 and ended in a

new inflationary outburst but, unlike the previous breakdowns,

the economy did not spin into hyperinflation. Instead, a new

fiscal package in February 1991 was sufficient to close the

remaining fiscal gap. This was followed by the April 1, 1991 Law

of Convertibility fixing the local currency to the dollar and

effectively proscribing money creation other than to buy net

foreign reserves. The convertibility program disciplines

monetary policy and limits the power of the government to

finance its deficit through inflation. The law markedly reduced

the foreign exchange rate risk to investors and the inflation

risk to business and labor--as long as the fiscal fundamentals

are in place to support it. The February 1991 program was able

to close the gap in large measure because the government's

sustained structural reform efforts had progressively improved

the foundations of public finance. The government had undertaken

difficult to reverse reforms in the legal framework,

institutions, and policies. These included institutional reforms

of the federal government, public enterprises, and

federal-provincial fiscal relations, and restructuring

liabilities with domestic and foreign creditors to adjust them

to serviceable levels. Other reforms have helped elicit

efficient private investment, notably trade, deregulation, and

financial sector reform.

Federal Government

The government undertook a major effort to improve revenues

through the implementation of a much-broad- ened and uniform

value added tax first to goods in February 1990, and later

extended to services in Novem- ber 1990. The government also

improved the efficiency of the tax administration in 1989,

establishing a control system for the largest taxpayers that

took effect in February 1991. The tax penalty law, adopted by

Con- gress in 1990, provided much needed sanctions for tax

non-compliance. The tax package of February 1991 improved the

quality of revenue mobilization substan- tially because it

eliminated export taxes, reduced pro- gressively during 1990 and

early 1991, deducted higher taxes on financial transactions from

the income/asset tax, and removed several minor taxes. In

December 1992 subsidies to industrial promotion were

substantially cut by replacing self-monitored tax deductions

with a tax bond program. These efforts cumulatively produced

dramatic rises in tax collections from the third quarter of 1991

on. The increase in value added tax collection allowed the

government to eliminate inefficient taxes, such as the fuel tax

and the stamp tax, in November 1992, and several specific sales

taxes in May 1993. Federal employment decreased from 671,000 to

284,000, including 103,000 layoffs and 284,000 teachers and

health workers transferred to provincial payrolls. This effort

was based on a ministerial reorganization that focused federal

activities on core objectives, and improvements in the civil

service system through an improved salary structure and

efficiency measures. The government was able to increase average

salaries and partially restore salary differentials. The

government took several measures to strengthen budgeting

procedures and expenditure controls. By 1993 it had eliminated

105 of the 151 earmarked accounts extant in 1990, and reduced

the coverage of earmarked taxes. The September 1992 Law of

Public Financial Management will permit comprehensive budgeting,

effective internal expenditure control, and provide for new

external auditing The government has embarked on several

reforms to separate the central bank from the nonfinancial

public sector and establish it as an effective independent

monetary authority. The elimination of the central bank's

domestic short-term interest-bearing obligations by means of

their conversion into external treasury bonds in January 1990 in

effect was a first step toward recapitalizing the central bank.

The Law of Convertibility established a money-creation rule that

effectively limits monetary policy and central bank inflationary

financing of public sector deficits. Since early 1991 the

central bank has published financial statements that reveal its

balance sheet; since April 1991 it has published its reserve

position weekly so the public can monitor implementation of the

Law of Convertibility. In September 1992 a

new law strengthened the central bank's autonomy, and further

restricted its ability to extend credit to the government and

the banking system. This measure reinforces the convert- ibility

law, and paves the way for an independent, disciplined, monetary

authority. In addition, the cen- trai bank intends to complete

the process of removing functions ancillary to the functions of

a monetary authority by transferring legal authority for failed

institutions to the courts.

Public Enterprises

The government has carried out one of the most impressive

privatization programs in the Western Hemisphere. The objective

was to reduce the budgetary burden of the enterprises, make the

firms more competitive, and increase the volume and efficiency

of new investment. The privatization program began in earnest in

1990 and gained credibility with the sale of national

telecommunications company in November 1990. The program removed

politics from price setting in the formerly vast segment of the

economy covered by the state. The change in the institutional

organization of these sectors cut off public subsidies to

consumers and labor groups benefitting from high wages and

excess staffing, and transfers for investment. The program also

improved public finances: about $9 billion in capital receipts

helped close fiscal accounts in 1991 and 1992 and external debt

was reduced by $12 billion. Major privatizations included

television stations, the telephone company, Aerolineas

Argentinas, gas distribution and transmission, and the majority

of the national oil company. It granted road and railroad

concessions to the private sector, privatized long distance

cargo lines, and sharply reduced the railway's work force. The

government privatized other public enterprises, including

defense industries, the nation's largest distributor of

electricity, ports and maritime transport, reinsurance, and the

entire power sector. Future privatization plans include the

national airport system.

Fiscal Relationships with the Provinces

The government also sought to restructure fiscal relation ships

with the provinces. The Coparticipation Law of 1988, fixed the

share of federal revenues automatically transferred to the

provinces at 58 percent. In August 1992 a portion of tax

revenues was assigned to the social security system before

computing revenue sharing. At the same time, the resources

provincial governments could access were limited by

progressively terminating central bank lending to provincial

banks. The government also reduced extra-coparticipation

transfers through the budget. To offset aggregate increases in

resources as national tax collection improved, the government

also transferred expenditures to provincial administrations,

notably secondary education and hospitals, and to the social

security system in August 1992.

Debt Restructuring

The final step in dealing with the government's insolvency

involved restructuring its debt obligations. The government had

financed its deficit through borrowing from the financial

system, suspending payment to external creditors, and

accumulating arrears with pensioners and suppliers.

Restructuring each of these required major initiatives. Although

the government ended new rediscounts to the housing and

industrial banks, and liberal rediscounts to provincial banks in

1988, the central bank continued money emission to finance the

treasury and its own deficit. In late December 1989, faced with

rising central bank deficits and the renewed threat of

hyperinflation, the government took the drastic step of

converting domestic, short-term (mainly seven-day),

interest-bearing obligations of the central bank into $3.5

billion 10-year dollar-denominated treasury bonds. This

virtually eliminated the central bank's quasifiscal deficit and

the monetary emission necessary to finance it-at the cost of

penalizing savers and reducing already low confidence in the

financial system. In April 1988 the government suspended payment

on its external debt to commercial creditors. By 1992 it had

accumulated $8 billion in arrears as part of a $32 billion

medium-term commercial bank debt. Public external debt was $61

billion. The government re-initiated partial payments in June

1990, and established a consistent record of paying about 25

percent of interest due. At the same time, it allowed external

debt to be used in exchange for the sale of assets, which

reduced the debt stock by $7 billion. The progressive

improvement in fiscal fundamentals in 1990/91 allowed the

government to begin negotiations with commercial banks on a debt

reduction deal. An external debt agreement signed on April 7,

1993, reduced $28 billion in commercial bank debt by

approximately 37 percent, and eliminated interest arrears. This

debt deal is expected to improve Argentina's creditworthiness.

The agreement formalized arrears in a 12-year uncollateralized

bond at LIBOR plus 13/16 with a 3-year grace period, after a

$700 million downpayment. Existing debt was exchanged for

collateralized par bonds with a fixed interest rate, or

collateralized discount bonds at 65 percent of face value paying

LIBOR. The new collateralized bonds will have a 12-month rolling

interest guarantee. For most of the last decade, the government

has paid only about half the legally mandated pensions owed

social security recipients. Arrearages were not recorded in the

fiscal accounts, but are estimated to be as high as $7 to 10

billion. To stop the accumulation of arrears, the government

modified coparticipation in tax revenues in favor of the social

securiry system in August 1992. Since then, the social security

system has run a small operating surplus. The government also

accumulated arrears in 1990 with suppliers through formal

suspension of payment on goods and services already provided,

and the health funds have arrears with their service providers

that will also result in new debt. Finally, the government, as

part of its income tax reform, suspended poorly designed loss

carry forward deductions for the corporate income tax, and

agreed to issue compensatory bonds. To settle these claims,

Congress authorized the government to issue consolidation bonds.

The service of this debt will be capitalized until 1997, but

payments on the order of $3 billion will be required in the last

years of the decade. The federal government's share of the

proceeds of the privatization of the state oil company is

earmarked for repurchasing some of the consolidation bonds.

Social Security Reform

The government has moved towards replacing a failed public

pension system. In mid-1992 it submitted a law introducing a

combined state/private system: the state would supply a uniform

basic pension financed on a pay as you go basis while the

private sector would supply pension funds. Membership in both

schemes would be mandatory. The lower house of the Argentine

Congress passed the law-with significant modifications--in May

1993. The government expects the legislative process to be

completed before the end of the year, allowing a new system to

be established in mid-1994.

Trade, Deregulation and Financial Reforms

In 1991 the government accelerated and largely completed a trade

liberalization program that began in laIe 1986, but had suffered

temporary reversals in 1989. Virtually all export taxes and

quantitative restrictionsexcept for automobiles--were

eliminated. The maximum ad valorem tariff was reduced from 115

to 35 percent. The deterioration in the trade balance in 1992,

a consequence of massive capital inflows motivated government to

use commercial policy to achieve effective devaluation within

the fixed exchange rate regime. Exporter rebates were raised

from 8 to 13 percent. On the import side, the tariff band was

narrowed to O to 20 percent. The government also increased a

flat tariff surcharge, called a statistical tax, from 3 percent

to 10 percent on a temporary basis. This led to an effective

depreciation of about 5 percent. In May 1993 the government

eliminated both tariffs and the statistical tax on capital goods

imports, but in July it provided protection to some paper and

textile products through temporary import quotas and tariff

surcharges. A major domestic deregulation decree in October 1991

ended a series of market-impeding rules, dissolved several

regulatory bodies, and unified pension and health insurance

payments to reduce evasion. Subsequent decrees have deregulated

pharmaceutical impons and ports. The industrial promotion

program and subsidies to Tierra del Fuego were markedly reduced

in November 1992. The publicly-owned housing and development

banks, long subject to political influence and dependent on

government financial support, are undergoing major

restructuring. Branches of the National Development Bank and the

National Housing Bank have been closed since March 1990 and

their staffs have been reduced by almost 75 percent. The

government is liquidating the development bank and closing the

housing bank's retail functions. It has established a second

tier bank to be managed, and ultimately owned, by the private

sector to mobilize financing for its investment needs. In

response to a short-lived run on the peso in mid-November 1992

the authorities strengthened their commitments to the fixed

exchange rate regime by permitting reserve requirements to be

met either in foreign or domestic currency, and equalizing

reserve requirements on foreign and domestic

currency-denominated checking accounts in domestic transactions.

In February 1993 these measures were complemented by lowering

reserve requirements and further deregulating commercial bank

lending to the private sector. Term deposits under 30 days were

eliminated to increase the average maturity of deposits in the

domestic financial system and reduce the risks of a run on the

banks. Finally, since April 1993, bank compliance with reserve

requirements is based on a four-week moving average, which

should reduce the volatility of short-term interest rates .

Over the last six months Argentina has taken meas- ures to

reduce interest rates and stimulate investment. In October 1992

it imposed a 2 percent per month ceiling on loans made by public

banks, a measure also aimed at stimulating restructuring of

these banks. In March 1993 it began auctioning subsidy credits

to banks, with the winner of the subsidy being the bank that

offers to charge the lowest rates to final medium- and

small-scale industrial borrowers. In May 1993 the authorities

an- nounced the extension of the Banco de Nacion's credit

lines-the largest official bank--and a reduction in its lending

rates from 1.8 percent to 1.6 percent per month. They also

declared that the bank's credit policy will be oriented toward

export-oriented activities as well as agriculture, industry,

mining, and tourism.

Recent Macroeconomic Developments

In 1992 the authorities continued to adjust the economy,

extending the recent good economic performance. GDP grew by 8.7

percent, and industrial production grew in the 12 percent range

for the second year in a row. Employment rose by about 10

percent and investment expanded briskly in 1992, rising from

12.5 percent to 14.5 percent of GDP. The increased investment

was financed by external savings, with gross national sav- ings

declining moderately to 9.3 percent of GDP. Public savings rose

by about 2 percentage points of GDP, while private savings

fell. Fiscal performance has improved notably in the last two

years. The overall balance moved into surplus in 1992 for the

first time in decades with an operational primary surplus of 2.0

percent of GDP. Tax revenues increased from 13.5 percent of GDP

in 1989 to nearly 24 percent between in 1992. In the same

period, public expenditures fell as a percent of GDP. Capital

spending and non-privatization receipts both declined slightly.

The fiscal surplus also was improved by the drop in dollar

interest rate, which cut accrued interest obligations by 1.3

percent of GDP. However, interest obligations still exceeded the

operational primary surplus slightly in 1992. Inflation

continues to decelerate. The annualized inflation rate in the

last quarter of 1992 was about 9 percent, compared to over 20

percent a year earlier. Nonetheless, inflation still exceeds

international rates, which is necessary to sustain the fixed

exchange rate regime . During 1992 capital inflows, jointly with

the economic expansion, contributed to an 84 percent increase in

imports; exports rose by 1 percent. As a result, the current

account deficit for 1992 reached 5.2 percent of GDP, up from 2

percent a year ago. Capital inflows of $12.0 billion, mostly

private, more than offset the current account deficit, allowing

a $3.4 billion accumulation of reserves. After signs of slowdown

in economic activity during January and February 1993,

industrial production recovered in March and April, with the

first quarter of 1993 marking the eleventh consecutive month of

economic expansion. Capital inflows recovered in the first

quarter of 1993, further strengthening the level of

international reserves. The monthly inflation rate between

January and March 1993 averaged 0.7 percent, about the same as

the last quarter of 1992.

Medium-Term Prospects

The government projects real growth averaging 6.5 percent over

1992-95. Over this period its fiscal program for aims at

generating a primary surplus sufficient to finance interest

obligations, thus eliminating the need for the inflation tax.

This involves efforts to raise the primary balance from about

$3.3 billion in 1991 to about $4. 1 billion in 1995. The success

of this program will largely depend on medium-term reforms to

improve the structural underpinnings of public finance, such as

social security legislation, labor reforms, and the evolution of

the fiscal relationships with the provinces, given the

increasing decentralization of power and responsibilities from

the center to provincial governments . This scenario is

attainable if the government continues to improve its fiscal

position, and if private markets generate a smooth transition to

a sustainable balance of payments and growth path. There are

significant risks to this program. The probability of adverse

events affecting the convertible peso declines, however, as the

government progresses on reforms that improve the fundamentals

of public finance. Past reforms in the public sector anchor

stabilization and are unlikely to be reversed during any

financial turbulence. Also, reserves are the highest in a decade

and cover the monetary base (although not the deposit base),

which would deter a speculative attack on the peso. Even if

problems give rise to pressure to alter the policy framework, in

all likelihood any emerging policy regime would of necessity

focus on maintaining fiscal balance and policies conducive to

private investment. Over the last few years Argentina has

enacted serious and difficult structural reforms with

considerable public support. The lack of alternatives to fiscal

discipline and price stability, and memories of the

hyperinflation of 1989/90, have made stability politically

popular. These facts are powerful ballast that is likely to keep

the ship of structural adjustment headed in the same direction,

even in a financial storm.